From Squeeze to Crush (Part Two of Two)

There is another, far more subtle yet sinister economic force at work which is, in the longer run, even more negative for US equity valuations than the profit margin crush discussed above. This is the erosion of the capital stock, which has been underway for some time. Capital erosion is arguably the single most pernicious if generally unseen side-effect of systematically inflationary monetary policies.

One of the major failings of mainstream, neo-Keynesian economics is that it doesn’t have a coherent theory of capital formation and, hence, no theory of its opposite, capital erosion or depreciation. For the most part, Keynesian analysis takes the capital stock as given and assumes that it grows at some long term potential growth rate, with the business cycle occasionally adding to or, in a recession, subtracting from this growth rate. The most obvious weakness of this approach is that, by taking the capital stock largely as a given, Keynesian analysis fails to consider, for example, how tax, regulatory, fiscal and even monetary policies can create incentives or disincentives for entrepreneurs to grow the capital stock over time.

The best explanation for this glaring omission is that growth (or erosion) of the capital stock is enormously difficult to model. Indeed, we would argue that it is impossible. One reason for this is the central role played by business confidence, what Keynes himself referred to as “Animal Spirits”. If entrepreneurs are confident, they invest. As such, most mainstream economics treats the bulk of changes in tax, regulatory, fiscal and monetary policy as essentially neutral when it comes to the capital stock. To entrepreneurs directly engaged in investing in and profiting from the capital stock, however, they are anything but.

There is an alternative school of economics, known as the Austrian school, which places the capital stock front and center, notwithstanding the impossibility of modeling it directly. The reason should be obvious: It is the capital stock that ultimately provides for all economic goods. If one wants to understand why economies grow and prosper or stagnate over time, rather than merely understand temporary fluctuations in output, one needs to focus on the capital stock. At the current juncture, with the central bank trying to reflate asset values with monetary inflation, it is important to understand just how such policies impact the capital stock over time. Sadly, rather than helping to grow the capital stock, in fact they erode it, even if we can’t easily quantify at what rate. We have addressed the topic of capital formation in a previous Amphora Report (Vol 1/15) but approach it here from a different angle, which is that of arguably the most prominent Austrian economist, Ludwig von Mises. With respect to monetary inflation and its destructive effects on the capital stock, von Mises made the following observation:

[Monetary inflation] falsifies accounts of profit and loss. If the value of money falls, ordinary bookkeeping, which does not take account of monetary depreciation, shows apparent profits, because it balances against the sums of money received for sales a cost of production calculated in money of a higher value, and because it writes off from book values originally estimated in money of a higher value items of money of a smaller value. What is thus improperly regarded as profit, instead of as part of capital, is consumed by the entrepreneur or passed on either to the consumer in the form of price reductions that would not otherwise have been made or to the laborer in the form of higher wages, and the government proceeds to tax it as income or profits. In any case, consumption of capital results from the fact that monetary depreciation falsifies capital accounting.

Von Mises is making a subtle but powerful point here, demonstrating how inflation, even in small amounts, distorts rational economic calculation, resulting in businesses consuming their capital when, in fact, they believe it is constant or growing. As such, one does not even need to believe that inflation damages business confidence to understand why it causes fundamental economic damage. Confidence can remain constant, yet inflation, though unseen on the surface, is undermining the economy by eroding the capital stock over time.

Now consider a booming business with soaring profits, yet one that pays out a substantial share of those profits as annual bonuses to senior employees and, of course, dividend payments to shareholders. Consider further that said business is operating in an environment of rapid monetary (and credit) inflation. Finally, let’s say that this business is a bank and that the bank’s capital is comprised of small amount of low-risk, liquid assets held on the balance sheet as a loss reserve for risky commercial or residential loans or securities holdings. Well, we have just described the US banking sector, which perhaps completely naïvely paid out huge bonuses (and substantial dividends to shareholders) in 2004-07, thereby unwittingly draining its real capital base immediately prior to the great financial crisis of 2008!

So do you see where the capital base went? To employees and shareholders of US banks, where it resides to this day. They are now happily “consuming” with the appropriated capital of their firms, some of which incidentally used to belong to US taxpayers, against whose wishes their so-called representatives in Washington, DC, decided to seize this capital at a critical moment in 2008, when the financial markets were demanding an immediate re-capitalization. This is quite possibly how von Mises, were he alive today, would describe the TARP program. Would he be as furious as US taxpayers are today? Perhaps. Von Mises was highly conservative in his use of language, but the TARP episode might have pushed him to use uncharacteristic vitriol.

[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]

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About John Butler:

John Butler has 17 years experience in the global financial industry, including European and US investment banks in London, New York and Germany. Recently, he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, responsible for development and marketing of proprietary, index-based quantitative strategies in global interest rate markets. Prior to DB, John was Managing Director and Head of European Interest Rate Strategy at Lehman Brothers in London, where his team was voted #1 by Institutional Investor. He has contributed to financial publications including the Financial Times, Wall Street Journal, Boersenzeitung and Handelsblatt.